Relevant to ACCA Qualification Paper F3
Understanding business partnerships is an important element of Paper F3. This article looks at the ways in which partnerships are formed, structured, and accounted for.
A partnership is a business formed by a minimum of two people who pool their resources together towards a common goal. Partnerships are generally formed through verbal arrangements or by deed – a legally binding document, drawn up by the partners, which safeguards their interests in the case of a dispute or misunderstanding. In lieu of a deed, the partnership is governed by local law (for example, the Partnership Act 1890 in the UK). The law does not offer solutions that would be contrary to the wishes of partners. Instead, it provides a set of standard procedures which can be followed by any partnership, and are therefore not tailored to any individual partnership.
This is the agreement made among the partners – the policies, formulated by the partners, under which the partnership business will be governed. Some of the principles that might be covered under such an agreement include:
In the absence of a partnership agreement, local law would come into effect. As an example, in the UK, the Partnership Act of 1890 sets out the following principles:
The advantages of a partnership are as follows:
The disadvantages of a partnership are:
Just as for a sole trader, a partnership also prepares an income statement/profit and loss account and balance sheet. The income statement/profit and loss account for a sole trader is the same as that of a partnership, as is the net assets part of the balance sheet. However, the capital part of the balance sheet is different from that of a sole trader. In order to prepare the capital part of the balance sheet for a partnership, there are three workings that must be completed:
Partners’ appropriation account – this working is used to share out the profit or loss of the business between the partners.
Partners’ current account – this working is done to show how much money is owed to the partners by the partnership business, or how much money is owed to the partnership business by the partners.
Partners’ capital account – this working is drawn up to check how much money is invested in the business by the partners.
Table 1 shows the appropriation account for the year ended 31 December 2005. In an exam, the examiner might include the partners’ salary as wages and salaries in the income statement/profit and loss account. This would mean that the net profit would need adjusting, which would involve adding the partners’ salary to the net profit given in the question.
Table 2 shows the current account as at 31 December 2005.
Table 3 shows the capital account as at 31 December 2005.
Here is an illustrated example of the workings of a partnership business, and the treatment of goodwill on the admission of a new partner.
Jess and Tash are in partnership and share profits and losses in the ratio of 6:4 respectively. Jess is allowed an annual salary of $28,000 and Tash is allowed an annual salary of $25,000. The partners prepare their accounts annually at 31 December. The balances on the partners’ current and capital accounts at 1 January 2005 are as follows:
Partners Current account Capital account
Jess 20,000 CR 250,000 CR
Tash 30,000 CR 400,000 CR
Due to the expansion and success of the business, the partners admitted Sash into the partnership on 1 April 2005. Sash introduced $500,000 as capital. On that date, the partners valued the goodwill as $200,000. After the admission of Sash, the partnership arrangements are as follows:
Prepare the following:
(a) Partners’ capital accounts as at 31 March 2005
(b) Partners’ appropriation account for the year ended 31 December 2005
(c) Partners’ current accounts as at 31 December 2005
(d) Balance sheet extract (Capital) as at 31 December 2005.
(a) Jess, Tash and Sash Partnership
Table 4 shows the capital account as at 31 March 2005.
Goodwill is the excess market value of the business over its book value. It is only fair that the partners who created this goodwill – Jess and Tash – should benefit from it, due to the hard work they have put into the business to get it up and running. If a partner joins the business when such surplus is present, then it is only fair that Sash pays for that benefit.
The accounting entries are:
Dr Partners’ capital account using new profit sharing ratio (PSR)
Cr Partners’ capital account using old profit sharing ratio (PSR).
(b) Jess, Tash and Sash
Table 5 shows the appropriation account for the year ended 31 December 2005.
Calculating the profit
Net profit as per question 526,000
Add bad debt written off (this should be written
off in the period that it relates to) 6,000
Partners’ salary should be treated in the
appropriation account and not the income statement/
profit and loss account 68,000
Net profit before appropriation 600,000
For the first three months to 31 March 2005, the net profit
would be: ($600,000 x 3/12) = $150,000 - $6,000 144,000
For the next nine months to 31 December 2005,
the net profit would be: ($600,000 x 9/12) = $450,000 450,000
(c) Jess, Tash and Sash
Table 6 shows the current account as at 31 December 2005.
(d) Balance sheet extract
Sash 51,595 414,000